In a recent edition of Value Investor Insight, John Buckingham of Al Frank Asset Management and analyst Mark Mowrey explain why they see strong upside in RealNetworks (NASDAQ:RNWK):
Your focus on diversification notwithstanding, we’re still going to ask for your favorite current ideas. Let’s start with one of your potential homerun technology stocks, RealNetworks (RNWK).
MM: Real has been around for a long time, providing one of the earliest players on which people could view net-based media. The three best-known tools were RealPlayer, Apple’s QuickTime and Microsoft’s Windows Media Player – as we know, Microsoft ended up dominating that space by bundling its player with Windows XP. While obviously a negative for Real, a resulting antitrust settlement with Microsoft has since 2005 given the company a lot of money to refashion its business and it has transformed itself into a broader-based online media company. Importantly, Real still has more than $500 million in net cash ($3.33 per share) on its balance sheet, which is more than half the current market value. The first major diversification move was to buy Listen.com, which ran one of the original online music sources called Rhapsody, a subscription-based online service with a user-friendly interface that allowed you to listen to a very large library of songs without owning them. Now, for $13 to $15 per month, you can listen to the entire Rhapsody library for as long as you pay for the subscription. If you have an MP3 player from someone like SanDisk, which has partnered with Real, you can download those songs. If you don’t plug that MP3 player in regularly to your computer to verify that you’re a subscriber, the songs become encrypted and you can’t listen to them any more. That business has grown nicely and Real now has around 2.7 million music subscribers. The company has been buying up online casual game companies and it’s now one of the largest game publishers for the PC. They have a long list of games for sale, including Sudoku, Scrabble and Mah Jong, and games now account for roughly 25% of Real’s sales. That business continues to mature and online gaming experiences today are very rich – with broadband, the sophistication of some games is close to what you would have seen on a Sony or Nintendo console two generations ago. With that increasing sophistication, there’s a rapidly growing market of people who are willing to pay for it. On the digital-media side of the business they’ve also expanded overseas, with one recent example being the purchase of a Korean mobile entertainment firm called WiderThan, which sells “ringback” tones that allow people to hear a specific tone when they call you.
What’s left of the original RealPlayer business?
MM: The company does still sell online media technology services, primarily to content or network providers who want to deliver content in a user-friendly and secure way. AT&T, for example, uses Real technology to deliver protected media like music to wireless handsets. In the latest quarter, 35% of Real’s $135 million in revenues came from businessto-business sales, with the rest coming from the consumer businesses. They’ve still continued to improve the RealPlayer. One feature I particularly like is the ability to right-click and download to your computer a streaming video that isn’t rights-protected. That came in handy when I wanted to watch Jim Cramer’s rant on CNBC several times a few weeks ago. If people start putting new RealPlayers on their computers in large numbers, that could provide an excellent platform to promote the games, music and other businesses.
The company doesn’t have a stellar record of profitability. Is that changing?
MM: Real has been modestly profitable on an operating basis but goes in and out of being in investment mode. If you add in the interest on the cash, they are making money. Like for a lot of the cash-isking companies we buy, we like the businesses they are in and think they’re at the point now where they can really start to scale net income.
How does that optimism translate into upside for the stock, currently trading around $6?
JB: Given that Real’s earnings are just starting to grow – forward earnings estimates are still only 11 cents per share for 2008 – we normalize the earnings to 85 cents a share before applying a P/E norm of 20x. Because the cash on the balance sheet is so important to the thesis, we may be overestimating how quickly they can get to that normal earnings level, but given all the reasons we like the stock, we’re comfortable giving it a target price of $17.